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Ch. 9: Inventory Lower of Cost or Market. The lower of cost or market is an exception to the historical cost principle. Future potential of the asset < original cost: Restate asset at market to replace cost. Loss charged against revenues of the period.

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Ch 9 inventory lower of cost or market
Ch. 9: Inventory Lower of Cost or Market

The lower of cost or market is an exception to the historical cost principle.

  • Future potential of the asset < original cost:

  • Restate asset at market to replace cost.

  • Loss charged against revenues of the period.


Lower of cost or market rules ceiling and floor
Lower of Cost or Market Rules: Ceiling and Floor

Market value is the replacement cost.

- The replacement cost must lie between a ceiling amount and a floor amount.

- Ceiling is the net realizable value (NRV= selling price less disposal cost).

- Floor is net realizable value less a normal profit margin.

  • The “designated market value” is the “middle” value amongst the replacement cost, ceiling, and floor

  • Designated market value compared against the Cost value to determine if an LCM write-down is needed.


Lower of cost or market ceiling and floor example
Lower of Cost or Market: Ceiling and Floor Example

Item Replacement Historical Ceiling Floor Final

Cost Cost Inv $

A $88,000 $80,000 $120,000 $104,000 $

B $88,000 $90,000 $100,000 $70,000 $

C $88,000 $90,000 $100,000 $90,000 $

D $88,000 $90,000 $87,000 $70,000 $


Recording the decline in market value
Recording the Decline in Market Value

Under the direct method:

DR. COGS

CR. Inventory

Under the indirect (allowance) method:

DR. Loss

CR. Allowance (contra- inventory acct.)


Lower of cost or market application
Lower of Cost or Market Application

The lower of cost or market may be applied:

  • Either directly to each item

    * most conservative approach

    * generally required for tax purposes

  • To each category, or

  • To the total of the inventory

    Whichever method is selected, it should be consistently applied.



Recording the decline in market value1

What if the Market Value Recovers?

Recording the Decline in Market Value

For subsequent increases in inventory value:

  • US GAAP prohibits the reversal of writedowns

  • IFRS requires the reversal of writedowns


Other valuation issues
Other Valuation Issues

  • Valuation at Net Realizable Value

    • Controlled market with a quoted price for all quantities

    • No significant costs of disposal

  • Relative Sales Value – “Basket Purchase”

  • Purchase Commitments


Valuation basis relative sales values
Valuation Basis: Relative Sales Values

  • Appropriate basis when basket purchases are made.

  • Basket purchases involve a group of varying units.

  • The purchase price is paid as a lump sum amount.

  • The lump sum price is allocated to units on the basis of their relative sales values.


Relative sales values example
Relative Sales Values: Example

Kirby Company buys three different lots (A, B and C) in a basket purchase, paying $300,000 for all three.

The lots were sold as follows:

A ($75,000); B ($150,000) and C ($200,000) for a total of $425,000.

What is the cost of A, B and C and the gross profit for each lot?


Relative sales values example1
Relative Sales Values: Example

Lot Sales Allocated Gross

Value Cost Profit

A $75,000 ($75,000/$425,000)

x $ 300,000

= $ 52,941 $ 22,059

B $150,000 $105,882 $ 44,118

C $200,000$ 141,176 $ 58,824

Totals $425,000 $300,000 $125,000



Purchase commitments
Purchase Commitments

  • Cancellable contracts

    • No entry or disclosure required

  • Formal, non-cancelable contracts

    • No entry, but disclosure required

    • If execution of the contract expected to result in a loss, then must be recorded

      DR Unrealized loss

      CR Est liability on purchase commitment


Inventory estimation techniques
Inventory Estimation Techniques

  • Inventory estimation used when:

    • a fire or other catastrophe destroys either inventory or inventory records

    • taking a physical inventory is impractical

    • auditors only need an estimate of the company’s inventory


Gross profit method to determine ei
Gross Profit Method to Determine EI

  • The Gross Profit Method uses estimated COGS (= actual sales X average gross profit on sales) to determine estimated ending inventory

  • Example:

    On 10/16/07, Whitsunday Company’s warehouse burned and its inventory was completely destroyed. The accounting records were kept in the office building and escaped harm. The following information was available as of 10/16/07:

    Net sales $426,000

    Beginning inventory 80,000

    Net purchases 300,000

    Average gross profit on sales 20%

    Use the above information to estimate the ending inventory lost in the fire using the gross profit method.


Gross profit method to determine ei1
Gross Profit Method to Determine EI

Beginning inventory $80,000

Net purchases 300,000

Cost of goods available for sale 380,000

Estimated cost of goods sold:

Net sales 426,000

Less: Est gross profit (85,200)(340,800)

Estimated ending inventory $39,200


Gross profit method example 2
Gross Profit Method Example 2

On December 31, 2007 Carr Company's inventory burned. Sales and purchases for the year had been $1,400,000 and $980,000, respectively. The beginning inventory (Jan. 1, 2007) was $170,000; in the past Carr's gross profit has averaged 40% of selling price. Compute the estimated cost of inventory burned.

BI

+ Net Purchases

= COGA

  • Estimated COGS:

    Net Sales

    less estimated gross profit

    Estimated Ending inventory


Retail inventory method
Retail Inventory Method

This inventory estimation technique is used when:

  • a fire or other catastrophe destroys either inventory or inventory records

  • taking a physical inventory is impractical

  • auditors only need an estimate of the company’s inventory

  • Appropriate for retail concerns with:

    • high volume sales and

    • different types of merchandise

  • Assumes an observable pattern between cost and prices.


Retail inventory method1
Retail Inventory Method

Steps:

  • Determine ending inventory at retail price

  • Convert this amount to a cost basis using a cost-to-retail ratio

    BI (at retail) + Net Purchases (at retail) – Net sales = EI (at retail)

    EI (at retail) X Cost-to-Retail ratio = estimated “EI” (at cost)


Retail inventory method example
Retail Inventory Method: Example

Given for the year 2002:

at costat retail

Beginning inventory $2,000 $3,000

Purchases (Net) $10,000 $15,000

Sales (Net) $12,000

What is ending inventory, at retail and at cost?


Retail inventory method example1
Retail Inventory Method: Example

at costat retail

Beginning inventory $ 2,000 $ 3,000

Purchases (Net) $10,000 $15,000

Goods available for sale $12,000 $18,000

less: Sales (Net) ($12,000)

Ending inventory (at retail) $6,000

Times: cost to retail ratio x

Ending inventory at cost

COGS


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